Svetlana Borovkova: Should institutional investors embrace tech, crypto and digital assets?

April 25, 2023

By Dr. Svetlana Borovkova, Head of Quant Modelling at Probability & Partners

Our rapidly changing world requires asset managers to keep pace with significant technological developments. Investing in tech has been a success story for the past two decades, as witnessed by a huge growth in the tech sector.

Nowadays, the tech sector is dominated by just five players: Meta, Amazon, Netflix, Alphabet and Apple, whose spectacular growth resulted in their combined value being a quarter of the entire S&P500. But, despite all this growth and the exuberance about tech investing, risks are currently quite high.

Investing in tech

Tech stocks have been highly volatile over the past year. Moreover, rising interest rates are bad news for tech and other growth stocks, which tend to win when interest rates are low (as they were in the past decade), and lose value in periods of high interest rates, such as the one we are entering now.

This does not mean we have to divest from tech. But to hold a successful tech portfolio, one should ride the current trends and identify stocks that are exposed to promising themes in the tech sector, such as cloud computing, AI and LLM (Large Language Models such as Chat GPT), 3D printing, gaming and blockchain technology. 

Institutional investors and digital assets

This brings me to the next question: should institutional investors (II) embrace digital assets and cryptocurrencies? Before 2018-2020, the crypto and digital asset sector was dominated by private investors, but from 2020 onward, more and more institutional investors entered the market.

The beginning of 2022 saw an explosive growth of institutional investors’ funds in digital assets. Then, at the end of 2022, the collapse of crypto exchange FTX led to a significant outflow of institutional investors’ capital from cryptos. 

However, compared to the previous inflow, this did not make a significant dent in II crypto-allocated funds. A recent study by Fidelity confirmed that a large percentage of institutional investors still see a potential for digital assets in their portfolios, especially in Europe and Asia, where the collapse of FTX did not resonate as much as in the US.

Risks and opportunities

Institutional investors who are cautious about investing in cryptos cite their high volatility as the main objection – which is fair enough, as high volatility is indeed an inherent feature of cryptocurrencies. However, it appears that in the short term many asset managers overestimate risks associated with cryptos and underestimate their long-term growth potential – a typical behavioral finance bias.

The same study by Fidelity showed that those institutional investors that embrace digital assets, take a long term view and believe that valuation of cryptos will increase over the long term. They also identify cryptos (especially specialist crypto hedge funds) as the best potential source of alpha. This is not an unfounded belief: only 1% portfolio allocation to cryptos over the last 7 years would have led to 14% overperformance.

This reason for investing in cryptos (i.e. their alpha potential, alongside the desire to invest in innovative technology) is different from the sentiment a few years ago, when the main reason for investing in cryptos was their low correlation to other asset classes and hence their potential for diversification – which is not seen as the main investment reason anymore.

Challenges and solutions

The main challenges to institutional investors’ adopting digital assets are:

• Lack of appropriate regulation and regulatory clarity
• Compliance and visibility
• Accounting challenges

Investing in cryptos calls for a new infrastructure and for investment products designed to bridge the gap between traditional investments and digital assets. Such products are rapidly appearing. Specialist crypto funds (by companies such as Fidelity, Schwab, Citadel, BlackRock collaboration with CoinBase, as well as by crypto hedge funds) offer diversified exposure to digital assets, and their products offer solutions to compliance and accounting challenges, as well as potential alpha generating opportunities. Also, soon NASDAQ will  launch an institutional crypto custody service.

Regulation of cryptos has been lacking so far: attempts by the SEC in the US to regulate crypto markets have drawn intense criticism. The main reason for this was the (correct) observation that digital assets require tailor-made regulation, which takes into account special features of the new technology, rather than rely on old-fashioned legislation, designed for traditional financial assets.

But change is coming: just a few days ago, the European Parliament passed the so-called MiCA legislation (Markets in Crypto Act), intended to regulate the cryptocurrency industry, to prevent anti-money laundering, improve supervision and disclosure and protect crypto investors. This is the World’s first comprehensive legislation aimed at crypto markets.

To summarize, digital assets promise a high alpha potential in the long term, and hence should be seriously considered by institutional investors. Legislation and investment solutions aimed at crypto investing are rapidly becoming . wihavailable. But crypto investing requires from institutional investors above all good risk management practices (such as the allocation in the current asset mix, choice of products or funds to invest in, risk-off signals), with which risk management firms can help.